Entrepreneurship

[An updated version of this article can be found at Entrepreneurship in the 2nd edition.]

The term entrepreneur, which most people recognize as meaning someone who organizes and assumes the risk of a business in return for the profits, appears to have been introduced by Richard Cantillon (1697-1734), an Irish economist of French descent. The term came into much wider use after John Stuart Mill popularized it in his 1848 classic, Principles of Political Economy, but then all but disappeared from the economics literature by the end of the nineteenth century.

The reason is simple. In their mathematical models of economic activity and behavior, economists began to use the simplifying assumption that all people in an economy have perfect information (see Information). That leaves no role for the entrepreneur. Although different economists have emphasized different facets of entrepreneurship, all economists who have written about it agree that at its core entrepreneurship involves judgment. But if people have perfect information, there is no need for judgment. Fortunately, economists have increasingly dropped the assumption of perfect information in recent years. As this trend continues, economists are likely to allow in their models for the role of the entrepreneur. When they do, they can learn from past economists, who took entrepreneurship more seriously.

According to Cantillon's original formulation, the entrepreneur is a specialist in taking on risk. He "insures" workers by buying their products (or their labor services) for resale before consumers have indicated how much they are willing to pay for them. The workers receives an assured income (in the short run, at least), while the entrepreneur bears the risk caused by price fluctuations in consumer markets.

This idea was refined by the U.S. economist Frank H. Knight (1885-1972), who distinguished between risk, which is insurable, and uncertainty, which is not. Risk relates to recurring events whose relative frequency is known from past experience, while uncertainty relates to unique events whose probability can only be subjectively estimated. Changes affecting the marketing of consumer products generally fall in the uncertainty category. Individual tastes, for example, are affected by group culture, which, in turn, depends on fashion trends that are essentially unique. Insurance companies exploit the law of large numbers to reduce the overall burden of risks by "pooling" them. For instance, no one knows whether any individual forty-year-old will die in the next year. But insurance companies do know with relative certainty how many forty-year-olds in a large group will die within a year. Armed with this knowledge, they know what price to charge for life insurance, but they cannot do the same when it comes to uncertainties. Knight observed that while the entrepreneur can "lay off" risks much like insurance companies do, he is left to bear the uncertainties himself. He is content to do this because his profit compensates him for the psychological cost involved.

If new companies are free to enter an industry and existing companies are free to exit, then in the long run entrepreneurs and capital will exit from industries where profits are low and enter ones where they are high. If uncertainties were equal between industries, this shift of entrepreneurs and of capital would occur until profits were equal in each industry. Any long-run differences in industry profit rates, therefore, can be explained by the different magnitudes of the uncertainties involved.

Joseph A. Schumpeter (1883-1950) took a different approach, emphasizing the role of innovation. According to Schumpeter, the entrepreneur is someone who carries out "new combinations" by such things as introducing new products or processes, identifying new export markets or sources of supply, or creating new types of organization. Schumpeter presented an heroic vision of the entrepreneur as someone motivated by the "dream and the will to found a private kingdom"; the "will to conquer: the impulse to fight, to prove oneself superior to others"; and the "joy of creating."

In Schumpeter's view the entrepreneur leads the way in creating new industries, which, in turn, precipitate major structural changes in the economy. Old industries are rendered obsolete by a process of "creative destruction." As the new industries compete with established ones for labor, materials, and investment goods, they drive up the price of these resources. The old industries cannot pass on their higher costs because demand is switching to new products. As the old industries decline, the new ones expand because imitators, with optimistic profit expectations based on the innovator's initial success, continue to invest. Eventually, overcapacity depresses profits and halts investment. The economy goes into depression, and innovation stops. Invention continues, however, and eventually there is a sufficient stock of unexploited inventions to encourage courageous entrepreneurs to begin innovation again. In this way Schumpeter used entrepreneurship to explain structural change, economic growth, and business cycles, using a combination of economic and psychological ideas.

Schumpeter was concerned with the "high-level" kind of entrepreneurship that, historically, has led to the creation of railroads, the birth of the chemical industry, the commercial exploitation of colonies, and the emergence of the multidivisional multinational firm. His analysis left little room for the much more common, but no less important, "low-level" entrepreneurship carried on by small firms. The essence of this low-level activity can be explained by the Austrian approach of Friedrich A. Hayek and Israel M. Kirzner. In a market economy, price information is provided by entrepreneurs. While bureaucrats in a socialist economy have no incentive to discover prices for themselves (see Socialism), entrepreneurs in a market economy are motivated to do so by profit opportunities. Entrepreneurs provide price quotations to others as an invitation to trade with them. They hope to make a profit by buying cheap and selling dear. In the long run, competition between entrepreneurs arbitrages away price differentials, but in the short run, such differentials, once discovered, generate a profit for the arbitrageur.

The difficulty with the Austrian approach is that it isolates the entrepreneur from the firm. It fits an individual dealer or speculator far better than it fits a small manufacturer or even a retailer. In many cases (and in almost all large corporations), owners delegate decisions to salaried managers, and the question then arises whether a salaried manager, too, can be an entrepreneur. Frank Knight maintained that no owner would ever delegate a key decision to a salaried subordinate, because he implicitly assumed that subordinates cannot be trusted. Uncertainty bearing, therefore, is inextricably vested in the owners of the firm's equity, according to Knight. But in practice subordinates can win a reputation for being good stewards, and even though salaried, they have incentives to establish and maintain such reputations because their promotion prospects depend upon it. In this sense, both owners and managers can be entrepreneurs.

The title of entrepreneur should, however, be confined to an owner or manager who exhibits the key trait of entrepreneurship noted above: judgment in decision making. Judgment is a capacity for making a successful decision when no obviously correct model or decision rule is available or when relevant data is unreliable or incomplete. Cantillon's entrepreneur needs judgment to speculate on future price movements, while Knight's entrepreneur requires judgment because he deals in situations that are unprecedented and unique. Schumpeter's entrepreneur needs judgment to deal with the novel situations connected with innovation.

The insights of previous economists can be synthesized. Entrepreneurs are specialists who use judgment to deal with novel and complex problems. Sometimes they own the resources to which the problems are related, and sometimes they are stewards employed by the owners. In times of major political, social, and environmental change, the number of problems requiring judgment increases and the demand for entrepreneurs rises as a result. For supply to match demand, more people have to forgo other careers in order to become entrepreneurs. They are encouraged to do so by the higher expected pecuniary rewards associated with entrepreneurship, and perhaps also by increases in the social status of entrepreneurs, as happened in the eighties.

The supply of entrepreneurs depends not only on reward and status, but also on personality, culture, and life experience. An entrepreneur will often find that his opinion is in conflict with the majority view. He needs the self-confidence that, even though in a minority, he is right. He must be persuasive, however, without disclosing too much information, because others may steal his ideas. Such shrewdness must, moreover, be combined with a reputation for honesty, because otherwise no one will wish to lend money to him for fear of deliberate default.

In identifying profitable opportunities the entrepreneur needs to synthesize information from different sources. Thus, the Schumpeterian innovator may need to synthesize technical information on an invention with information on customer needs and on the availability of suitable raw materials. A good education combined with wide-ranging practical experience helps the entrepreneur to interpret such varied kinds of information. Sociability also helps the entrepreneur to make contact with people who can supply such information secondhand. For low-level entrepreneurship, education and breadth of experience may be less important because information is less technical and more localized. Good social contacts within the local community are more important here. Key information is obtained by joining the local church, town council, residents' association, and so on.

The culture of a community may be an important influence on the level of entrepreneurship. A community that accords the highest status to those at the top of hierarchical organizations encourages "pyramid climbing," while awarding high status to professional expertise may encourage premature educational specialization. Both of these are inimical to entrepreneurship. The first directs ambition away from innovation (rocking the boat), while the second leads to the neglect of relevant information generated outside the limited boundaries of the profession. According high status to the "self-made" man or woman is more likely to encourage entrepreneurship.

There seems to be considerable inertia in the supply of entrepreneurs. One reason is that the culture affects the supply, and the culture itself changes only very slowly. Entrepreneurship is one of the major avenues of social and economic advancement, along with sport and entertainment. But the Horatio Alger myth that the typical entrepreneur has risen from rags to riches disguises the fact that as Frank Taussig and others have found, many of the most successful entrepreneurs are the sons of professionals and entrepreneurs. They owe much of their success to parental training and inherited family contacts. Thus, in most societies there is insufficient social mobility for entrepreneurial culture to change simply because of the changing origins of the entrepreneurial elite. In any case, "self-made" entrepreneurs often adopt the culture of the elite, neglecting their business interests for social and political activities and even (in Britain) educating their children to pursue a more "respectable" career.

In the long run, though, changes can occur that have profound implications for entrepreneurship. In modern economies large corporations whose shares are widely held have replaced the family firm founded by the self-made entrepreneur. Corporations draw on a wider range of management skill than is available from any single family, and they avoid the problem of succession by an incompetent eldest son that has been the ruin of many family firms. Corporations plan large-scale activities using teams of professional specialists, but their efficiency gains are to some extent offset by the loss of employee loyalty that was a feature of many family firms. Loyal employees do not need close supervision, or complex bonus systems, to make them work, because they are self-motivated. Historically, family firms have drawn on two main sources of "cultural capital": the paternalistic idea that employees are adopted members of the founder's family, and the founder's own religious and moral values. The first is effective only within small firms.

A modern corporation that wishes to build up a family spirit must do so within its individual business units. These units can then be bonded together by a unifying corporate culture—the modern equivalent of the founder's system of values. The dissemination of corporate culture may be assisted by the charisma of the chairman or chief executive. This suggests that senior management in the modern corporation requires not only entrepreneurial skills, but also leadership skills—which means the ability to inspire trust and affection, rather than just fear, in subordinates. The need to combine entrepreneurial skills and leadership skills is, of course, universal, but its significance has increased as organizations have become larger and societies have abandoned traditional religions for secular values.

About the Author

Mark Casson is a professor of economics at the University of Reading in England.

The cuneiform inscription in the Liberty Fund logo is the earliest-known written appearance of the word "freedom" (amagi), or "liberty." It is taken from a clay document written about 2300 B.C. in the Sumerian city-state of Lagash.